The Labour Market Lecture 23 academic year

The Labour Market Lecture 23 – academic year 2014/15 Introduction to Economics Fabio Landini

Questions of the day • How does the labour market function? • Why are some workers unemployed? • What does the unemployment rate depend on?

What do we do today • Quick review of the model of demand supply (Part I - Microeconomics) • Construction of the model WS-PS • Determination of the equilibrium • Analysis of the determinants of unemployment

Premise Labour market -> Analysis of medium period In this class we examine the functioning of the labour market and the determinants of unemployment In the next class we will come back to the passage from short period to medium period using part of the results obtained today

Demand supply of labour It is the simplest model to study the labour market Firms “demand” labour -> the labour demand (DL) point out how many workers the firms want to hire at the market wage (W) It follows that the higher the wage the lower the number of workers that the firms are willing to hire DL is a decreasing function of the wage

Demand supply of labour Workers “supply” labour -> the supply of labour (SL) tells us how many workers are willing to work at the market wage (W) It follows that the higher the wage the larger the number of workers that are willing to work SL is an increasing function of wage

Demand supply of labour In equilibrium -> DL = SL -> Point E in the graph NE is the number of workers that are employed WE is the equilibrium wage W WE SL E DL NE N° workers

In equilibrium: • Along DL -> firms hire the number of workers that they wish • Along SL -> workers that wish to work are hired -> there is no unemployment W SL E DL NE N° workers

Demand supply of labour In real economies, however, there is unemployment To explain the existence of unempl. -> WS-PS model

Construction of the WS-PS model In the WS-PS model : • Firms fix the prices of the goods that are produced • Firms and workers negotiate on wages Let’s examine them separately: • Determination of wages • Determination of prices

Construction of the WS-PS model The determination of wages Wage negotiation is explained by different theories Summary of the main theories -> “wage setting” equation (WS) W = PE F(u, z) -+ where W is the wage, PE is the expected prices, u is unemployment, and z is institutional variables of the labour market

Construction of the WS-PS model Let’s examine the different components of this equation W = PE F(u, z) a) W depends on P • Workers are not interested in the amount of money they receive but in the quantity of goods that they can buy with their wage -> • Workers are interested in the wage “in proportion” to the level of prices

Construction of the WS-PS model b) In the equation we have PE rather than P • Wages are negotiated ahead of time and remain fixed for a certain period of time so that the level of prices is not known with certainty -> • Wages depends on “expected” prices -> PE (Important to distinguish between short and medium period) c)F(u, z) -> W depends negatively on u • u -> Greater competition among workers -> Workers’ bargaining power -> W

Construction of the WS-PS model d)F(u, z) -> W depends also on institutional variables z (positive for convention) The latter include: • The level of unemployment subsidies Subsidies -> Compensations requested to work • Minimum wage Minimum W -> Workers’ wage requests

Construction of the WS-PS model Let’s go back to the WS equation -> W = PE F(u, z) For the moment, let’s assume that price “expectations” are correct -> PE = P In this case: WS -> W = P F(u, z) By rearranging we obtain W/P represent the wage relative to the level of prices, i. e. the “real wage”

Construction of the WS-PS model Let’s draw the equation in a (W/P, u) diagram F is decreasing in u -> the curve WS is decreasing W/P WS u

Construction of the WS-PS model The determination of prices Firms’ behaviour -> production Two main simplifications: • Only one input -> labour (N) • The total product (Y) is equal to the amount of labour that is employed -> Y = N This implies that the cost to produce one unit of Y is equal to the cost to employ one worker, which is equal to the wage W

Construction of the WS-PS model Let’s assume that firms fixe the price on the basis of the unitary cost of input following the rule: Price= Unitary cost X (1+m) where 0<m<1 is m the so-called mark-up. Important: m is a % of “refill” on costs For instance, if m =10% the price is equal to the costs increased by 10%

Construction of the WS-PS model In our case the unitary cost is W so that: P = W(1+m) -> “Price setting” equation Important: the dimension of mark up depends on the degree of competition among firms In particular: • competition among firms -> m • In the limit, perfect competition implies m = 0 and P=W

Construction of the WS-PS model Let’s go back to equation PS -> P = W(1+m) After some algebraic passages we obtain ->

Construction of the WS-PS model We draw the PS in a (W/P, u) diagram In the PS the real wage W/P does not depend on u -> the curve PS is an horizontal line W/P PS u

The equilibrium in the labour market We defined the two curves that describe the determination of wages (WS) and prices (PS) Let’s now consider the two curves together in the same graph

We draw the two curves In E we are both on the WS and on the PS -> E is the equilibrium In E there is unemployment -> u = un un is the “natural” rate of unemployment W/P E PS WS un u

The determinants of unemployment In the WS-PS model the system presents some positive degree of unemployment in equilibrium This happens in because of two components of the model (that are absent in the standard supply and demand model): • Competition among firms is not perfect in the goods market • Presence of a wage negotiation mechanism

The determinants of unemployment The equilibrium level of unemployment un depends on the same factors In particular un is influenced by: • The degree of competition among firms • The institutional characteristics of the labour market To understand these relationships let’s look at the effect on un of : • competition among firms • Changes in the labour market legislation ( unemployment subsidies)

Let’s start from E and in competition -> downward Effects: E -> E’ and mark up m -> -> PS shifts un W/P E PS E’ PS’ WS un un’ u

Let’s start from E and subsidies -> subsidies z -> Effects: E -> E’ and F(u, z) -> WS shifts upward un W/P E E’ PS WS’ WS un un’ u

The determinants of unemployment The above results show that: • Competition among firms -> un • Changes in the labour market legislation affects un (e. g. Unemployment subsidies -> un) The rate of unemployment un depends on some structural factors (how market functions) -> for this reason is called “natural rate of unemployment”